What Are the Disadvantages of an S Corporation? Can You Be an Llc and an S Corp?
Considering S Status
An S election means that a corporation has chosen a special set of tax rules. It has no effect on the corporation for any other purposes (for example, liability protection under state law). Thus, S status lets business owners combine the legal and economic benefits of a corporation with favorable taxation as a pass-through entity. However, there are potential drawbacks to S status and situations where not electing S status (that is, remaining a C corporation) is more beneficial.
Observation: To be an S corporation, the taxpayer must make an affirmative S election. Also, it may help to note that the terms “S corporation” and “S election” come from the fact that the rules for S corporations are found in Chapter 1, Subchapter S of the Internal Revenue Code—thus, the use of “S” when referring to this type of corporation.
Distributions
S Election Considerations
When an S election can be advantageous:
• New business expected to incur start-up losses, which will be passed through to the shareholders.
• A profitable, cash-rich corporation that can distribute enough cash to shareholders to pay the income tax on the pass-through income.
• An established corporation in a mature industry that accumulates earnings even when substantial dividends are paid can avoid double taxation on distributions and is not exposed to the corporate-level accumulated earnings tax.
Situations where S Election may not be advantageous:
- Rapidly growing corporation in a competitive market that will use cash to fund growth. Then, the corporation may be unable to distribute enough cash to shareholders to pay their tax on the S corporation income.
- Most of the corporation’s shareholders are employees. Common fringe benefits provided to owner/ employees that are otherwise tax-free will be taxable if the corporation elects S status.
- One class of stock rule limits corporation’s ability to raise capital.
- Corporate income is expected to be less than $100,000. Here, taxing the income at the graduated corporate rates may result in less tax than taxing it at the shareholder’s rates, especially if the corporation doesn’t intend to make significant shareholder distributions.
Qualification
Family Member Shareholders
All family members (and their estates) are treated as one shareholder for purposes of determining the number of shareholders in an S corporation.
Family members include:
• A common ancestor (whether or not alive) and that ancestor’s lineal descendants (up to six generations), as well as the ancestor’s and descendants’ spouses and former spouses.
Observation: The six-generation limit does not provide much hindrance to counting family members as one shareholder because the first generation to be excluded would be a great-great-great-great grandparent of a shareholder in the youngest generation.
• A husband and wife (including divorced spouses who are family members).
• The estate of a deceased family member when the estate or a testamentary trust holds stock in the S corporation.
• Beneficiaries of certain trusts owning the S corporation stock when the beneficiaries are family members.
• The owner of a disregarded entity, such as a singlemember LLC, if the owner is a family member.
Caution: Treating separate shareholders as one applies only when determining if the corporation has exceeded the allowable number of shareholders. Shareholders are treated separately for other purposes, such as the pass-through of the S corporation’s items of income, gain, loss or deduction. Furthermore, if a corporation is making the S election, each person holding shares must separately consent to the S election.
Observation: The family member rule greatly expands the number of actual shareholders an S corporation is permitted to have. For example, if 20 members of 50 different families held stock in an S corporation, the actual number of shareholders would be 1,000, but for purposes of the number of shareholders test, there would be only 50 shareholders.